OPPORTUNITIES
for ACTION
Variabilization
STRATEGY
This article initiates a series on business model innovation.
W
hat keeps CEOs awake at night in difficult times?
Fixed costs.
But fixed costs can be transformed into variable
costs through a process known as variabilization. Organizations
that variabilize their fixed costs can master the business cycle
rather than be whipped by it. The technique can be applied within your own organization (back-end variabilization) or leveraged
to create value-added solutions for your customers ( front-end
variabilization).
Why Have Fixed Costs Become
Less Desirable?
■ Variabilization is the transformation
of fixed costs into variable costs
■ There are two varieties of variabilization:
• Back end, through which a company variabilizes its own costs
• Front end, through which a
company designs and fields offerings to variabilize its customers’
costs
■ The variabilization approach can
enhance the agility and flexibility of
your business model
Fixed costs have merit. They turn growth into scale effects and
cost advantage—and ultimately into profit. The 1970s was the
golden age of fixed costs, as companies rode the experience curve
to market leadership and superior profitability: “cut price; costs
will follow” was the management mantra.
Such a strategy can still work when technology is stable, factor
costs comparable, and market segments large and homogeneous.
Unfortunately, those market characteristics are no longer widespread. Today, in many sectors, a company can lead in market
share and volume and still lag behind rivals in profitability. Some
so-called leaders even lose money: think of companies in the automotive and airline industries and certain segments of the computing industry.
In fact, fixed costs have increasingly become a liability. They turn
market declines into significant losses. They restrict agility. Many
challengers with novel business models have succeeded because
incumbents, tied down by fixed costs and fixed assets, could not
outmaneuver the newcomers. Even in expansionary times, when
fixed costs provide a leverage point for profits, such costs might
also constrain the growth of companies that cannot scale up their
activities fast enough.
But imagine a world in which all your costs are variable: If a
downturn or a new entrant cuts 10 percent of your sales, your
Variabilization
profit dips by only 10 percent. If you need to triple a business activity in three years, you can concentrate on the sales
side, and the cost side will take care of itself. In this world,
profit is achieved not in the traditional manner—through
amortization of fixed costs—but instead through speed and
agility.
Although such a world does not yet exist, it is possible today
to make significant moves in that direction.
Back-End Variabilization: Redesigning
Your Own Cost Structure
Why should you need to own something to use it?
Accor, a leading hotel chain, used to own the real estate of
many of its hotels. But this approach trapped a lot of capital
and represented a big fixed cost. So the company sold its
buildings to a financing house in exchange for a fixed rent.
It then went one step further, renegotiating the rent as a
percentage of hotel revenue. Real estate is now a variable
cost for many Accor hotels. Of course, this means that Accor
transferred risk to the financing house and must pay a small
premium. But today, Accor is much more resilient in the face
of the traditional cycles of its industry and can keep investing when its competitors are forced to stop.
A leading player in construction materials decided to variabilize 80 percent of its costs. It had already outsourced its
truck fleet, a high-cost item, but the truck leases themselves
remained a fixed cost. The company renegotiated the lease
agreement to base payment on actual usage. Separately, the
engineering team devised a new concept for the organization’s local plants: the movable factory. The cost per unit of
capacity is slightly higher under this approach, but it enables
the company to match local capacity to local demand by
moving capacity rather than adding it. As a result of these
two efforts, the company reached its target of 80 percent
variabilization in less than two years.
Now imagine turning to your major suppliers and asking
them to buy back all the assets they have sold you (which is
good for your cash flow). Then imagine negotiating contracts that require you to pay for those assets as you use
them or, even better, as a percentage of your sales. Consider,
for instance, your IT assets: your supplier could pay you a
lump sum to take them back and, going forward, invoice
you for IT services at an agreed percentage of your sales.
You would have true control of your IT costs. You could also
go one step further, with a contract that annually reduces
invoiced costs by a specific percentage reflecting productivity gains in IT. Sound like a dream? Some major IT providers are already considering introducing precisely this offer.
2
Why would suppliers ever accept these terms? We explore
this question next.
Front-End Variabilization: Developing
Variabilization Solutions for Your Clients
If turning fixed costs into variable ones is highly desirable,
then companies that can offer their customers variabilization solutions will enjoy a competitive advantage. The experience of pioneers shows that pursuing such a solutions
strategy can even be highly profitable.
In the mid-1980s, Rolls-Royce and, soon aer, General Electric radically changed the way they sold aircra engines.
They started to sell engine “power by the hour” instead of
separately selling engines plus financing plus maintenance
plus spare parts. The airlines, which paid nothing up front,
paid on the basis of the utilization of their planes. In this
way, Rolls-Royce and GE turned what was a fixed cost for the
airlines into a variable cost. The offer was appealing, and
Rolls-Royce and GE won share in the engine market. They
also increased revenue per client (by bundling together
equipment, service, and financing) and extracted a premium—better margins—at the same time.
GE extended the concept to selling steam turbines and medical equipment. Xerox used it to sell copiers by the copy,
with the usage charge including maintenance and upgrades.
This model also works in consumer markets such as mobile
telephony, in which customers are offered “free” cell phones
and pay for usage by the minute (with minimum usage and
a contractual commitment to a certain duration of service).
Of course, this strategy is not without risk: front-end variabilization requires you to take more assets on board. Aer all,
you still own your “sold” products.
Moreover, isn’t this a dangerous model in a downturn?
Won’t customers reduce usage, causing revenue to decline?
To a degree, yes. But if you were selling capital equipment,
a downturn might cause revenues to plunge 50 percent or
more. By contrast, our experience suggests that a variabilized offering would fare much better, with sales declines in
the range of 10 percent. Variabilization solutions represent
a resilient business model.
By retaining the assets and selling usage, companies can
also optimize costs across the value chain. The solution provider can optimize the total life-cycle cost of owning the
asset, with the potential for significant savings over the long
term. It may well make better economic sense, for example,
to build a more costly engine or copier at the outset if those
incremental investments lead to much lower costs for op-
Variabilization
eration, maintenance, and repair. Furthermore, because assets can be redeployed from one client to another, providers
of variabilization solutions can mitigate risk that a particular client might prove unable or unwilling to bear. A provider of variabilization solutions can leverage economies of
scale and experience across its portfolio of clients’ equipment, creating far more economic value from those assets
than could any individual client—even the largest in its
industry.
But if all clients benefit from the value created by suppliers
and even the smallest new entrant can access competitive
variable costs on the use of large and complex assets, what
will happen to entry barriers and the competitive advantage
of leaders?
What Does Variabilization Mean
for Competitive Advantage?
Variabilization reduces entry barriers. In more and more
domains, you can find outsourcers that can do for you what
used to require a set of fixed costs and specific skills.
3
Variabilization means in many cases that companies will sell
their current assets back to their suppliers. They will let suppliers optimize those assets and pay for them on the basis of
usage or, even better, as a percentage of sales. Variabilization
means truly moving from being a supplier to being a business partner. (See the exhibit “Ten Steps to Resilience: Getting Started with Variabilization.”)
A good example is the partnership between Solvay, a pharmaceutical company, and Quintiles Transnational, a leading CRO. By the terms of their contract, the cost of studies
that Quintiles conducts for Solvay varies depending on the
outcome of each study. In exchange for the variable compensation and transfer of risk, Quintiles secured a multiyear contract with significant upside potential. Quintiles
can earn a lot—but only if Solvay succeeds. Together, the
two are stronger: When the contract was made public, the
share price of each company rose. Solvay benefits from
lower risk in its business model, and Quintiles gets a chance
to participate more fully in the upside of the work it performs.
In this new world of variabilization, the following will occur:
This does not mean that leaders lose all scale advantage.
Larger airlines, for example, will get a lower unit price on a
power-by-the-hour contract than their smaller competitors.
But the trend toward variabilization does have the potential
to transform the nature of competitive advantage by shiing
the emphasis away from competing exclusively on scale to
competing on agility, value chain orchestration, and risk
management.
Of course, there are boundaries that should not be crossed.
One should not risk making the value of a unique asset
available to competitors by variabilizing it through an outsourcer.
It is, however, possible to variabilize a unique fixed cost while
keeping it internal. A biotech company with a promising
drug in development, for example, could variabilize some or
all of the fixed costs of the multiyear research by having a
partner pay for those costs now as prepayments against royalties on future sales. Today’s fixed costs become tomorrow’s
percentage-of-sales costs.
Long-Term Impact: Asset Migration and
Open Business Models
Variabilization is growing. Call center outsourcers, vehicleleasing companies, contract research organizations (CROs),
contract sales organizations, and so-called toll manufacturers
are surfing this wave and seeing double-digit growth even in
the face of a challenging economy.
◊ Assets, risks, and activities will migrate to those companies that can best optimize them.
Ten Steps to Resilience:
Getting Started with Variabilization
1. Map the fixed costs in your business. Be careful: some
seemingly variable costs have hidden fixed components.
2. Engage your suppliers in a dialogue about variabilization
solutions—with or without asset buyback options.
3. Be ready to accept variable costs that seem more
expensive per unit than your fixed-cost approach. The
benefits of variabilization are worth a premium.
4. Be bold. Ask your suppliers to define payment as a
percentage of your sales. Turn your suppliers into true
business partners: win together, lose together.
5. Be ready to give your chosen suppliers a broader bundle
that includes maintenance, financing, and other
services—along with a long-term commitment.
6. Analyze your customers’ cost structures, map their fixed
costs, and design variabilization solutions for them.
7. Look to variabilization pioneers for inspiration.
8. If a variabilization solution requires taking on too much
risk and too many assets, consider partnering with a
financing specialist.
9. Be bold in design but careful in implementation:
overinvest—especially at the start.
10. Sleep better at night.
Variabilization
4
◊ Companies’ cost structures will become more variable,
making their business models more resilient.
◊ Suppliers and customers will become more and more integrated. Successful business models will be more open to
the outside world—and increasingly, companies will be
orchestrators rather than owners of their operations.
◊ Competitive advantage will shi away from scale and toward agility, risk management, and coordination across
the value chain.
So who is and who will be the variabilization leader in your
industry?
Nicolas Kachaner
Nicolas Kachaner is a senior partner and managing director in the
Paris office of The Boston Consulting Group.
You may reach the author by e-mail at:
[email protected]
To receive future publications in electronic form about this topic
or others, please visit our subscription Web site at www.bcg.com/
subscribe.
© The Boston Consulting Group, Inc. 2009.
All rights reserved. 3/09